A richer market may be here to stay

Investing tip: Is it a new bull market or a sucker's rally?

DeborahAdamson

LOS ANGELES (CBS.MW) - It might not be the world according to GARP anymore.

GARP, in the investing realm, means growth at a reasonable price. But like that 1982 Robin Williams movie, "reasonable" stock prices relative to their historical average may be a thing of the past.

In recent years, stock valuations reached record highs -- even with the economic downturn.

Standard & Poor's this week said the price-to-earnings ratio on its S&P 500 Index -- a widely followed barometer of the market's valuation -- reached an annual record of 46 for 2001. (S& P uses income from continuing operations figures, not pro forma.) By comparison, the historic average is 14.

Increased demand from stock, mutual-fund and 401(k) investors, the technology revolution and benign inflation should keep the market's valuation well above its historical average, proponents of higher valuations say. The argument heard before the market peaked and used to justify buying tech stocks with no profits whatsoever - "it's different this time" - still has a lot of validity, they say.

"The historical average is no longer valid," said Joe Liro, equity markets strategist at Stone & McCarthy Research, a financial markets consulting firm. "I doubt if we'll ever see the S&P 500 Index price-to-earnings ratio at 14 on a sustained basis ever again."

But critics point out there's more than a century of data showing market declines following abnormally high stock valuations. Thus, stocks could be headed for a bad fall. Learn from the past, they say.

"We had a peak in the S&P (500) and Nasdaq in March 2000," said Robert Shiller, a Yale economics professor. "They're quite a bit below that now and there's a good chance they'll go down further."

Pu Shen, an economist at the Federal Reserve Bank of Kansas City who has written about the subject matter, said a case could be made for both sides. While there's plenty of historical data to support the view that the P/E would float back to the average, she said, one cannot rule out that possibility that "history may not repeat itself."

A richer market or a crash?

A key measure of the market's expensiveness is the price-to-earnings ratio, or P/E. It's calculated by taking the latest price of a stock or market index and dividing by the earnings per share, whether it reflects the past four quarters or a future year.

While a depression in corporate earnings has pushed the P/E higher - when the E in P/E falls, it boosts the ratio's value - this valuation measure, nevertheless, has been advancing in recent years.

In fact, some experts believe the historical P/E average of 14 is no longer the best benchmark, given today's massive demand for stocks.

Liro lists four factors supporting his argument that the P/E would no longer maintain its historical average:

Over the last two decades, higher-growth companies in the technology, health care and communications sectors have been replacing the industrial businesses in the S&P 500. Investors would be expected to pay more for stocks with higher long-term growth rates - boosting P/Es.

With half of U.S. households owning mutual funds, record numbers of people - especially baby boomers -- are investing in stocks. That increases demand, driving stocks higher.

Changes in accounting rules to make the calculation of earnings more conservative. In general, this would result in lower profits, which would push the P/E higher.

A reduction in the equity risk premium, versus other investments. Typically, stocks have returned more than other investments, such as bonds, because they carry higher risk. The difference in the returns is the risk premium. But the premium is shrinking as more people become comfortable buying stocks, the business cycle stabilizes due to improved news, and low inflation in line with historical trends.

But Shiller is not convinced.

The P/E and other valuation ratios have reached an "unprecedented level," he wrote in an academic report last year with John Campbell, an economics professor at Harvard University.

Even if there were structural changes in the economy and financial markets, the richly valued market hints at a "poor stock market outlook than has ever been seen before," with the worst-case outcome being "catastrophic 10-year decline."

They contend that the mean-regression theory basically still holds. This means that the stock market may plunge to new depths or soar to great heights at times, but in the end, it would trend back to its average, even if it doesn't hit the number exactly.

As for the argument that baby boomers favor stocks and tend to be less risk averse than previous generations, the economists say this might hold true when the economy is running strong. But in weaker economic conditions, attitudes of boomer investors might shift.

Their report, which looked at market valuation ratios from 1871 to 2000, calculates a P/E of 28 for 1929, the year of the stock market crash and preceding the Great Depression. That P/E is 40 percent lower than the P/E for 2001 as calculated by Standard & Poor's.

Does that mean the S&P is headed 40 percent lower?

Shiller doesn't think the market would dive that far, but he notes that there are "real concerns that future price growth will be small or negative" over the next 10 years.

His advice to investors? "Look more favorably at investments other than high P/E stocks," he said. Stocks may be more exciting, but "remember that there are bonds out there and real estate."

Investing tip:

Since the Dow Jones Industrial Average closed above 10,000 two weeks ago -- the first time it's done so since August 2000 -- and continues to move higher, there's talk that the worst may be over.

Not so fast, said Mike Norman, a money manager and publisher of the Economic Contrarian Update report. History is full of examples of bear market rallies that occurred after the bursting of a speculative bubble, like the Internet boom of the late 1990s, he said.

Indeed, the years following the 1929 stock market crash and the meltdown in Japan's Nikkei stock index were peppered with rallies fueling false investor hopes that good times had returned.

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